Lockdowns announced to combat the COVID-19 pandemic have led to a massive economic slowdown, which has impacted already stressed Indian corporates. In such a scenario, ICRA’s rated portfolio of debt instruments has witnessed an increase in the pace of downgrades while the upgrades have nearly dried up. Put simply, the creditworthiness of some corporates has gone down. Therefore, fixed-income and debt fund investors should tread with caution.
Corporates face rating downgrades
A majority of the 315 non-financial sector entities that saw negative rating actions between March 1, 2020 and May 15, 2020 are affected by the pandemic outbreak. While 150 entities saw rating downgrades, the rating outlook was changed to negative for 122 debt issuers. Though only 9.6 per cent of the rating portfolio of ICRA has been impacted by negative actions, the pace has gone up as the monthly downgrades have increased by 22 per cent. “Out of the top ten sectors which witnessed a negative rating action since March 2020, a large proportion were those that were categorized as “High Risk” by ICRA. These included sectors such as aviation, hotels and restaurants, retail, and ports,” states an ICRA note.
Negative rating actions such as downgrades, outlook changes and placing the issuer under watch indicate deteriorating fundamentals of the issuer. It means that the repayment capacity of the issuer of debt instruments is strained. There is a possibility of default on repayments of principal and/or interest.
“Though the rising downgrades indicate rising corporate stress at a broad economy level, the downgrades are seen in some sectors where fundamentals are weak. Most of these sectors are discretionary in nature and they are not heavily indebted. Also the mutual fund industry does not have exposure to these sectors and to that extent bond funds are insulated so far,” says Kumaresh Ramakrishnan, CIO-Fixed Income, PGIM India Mutual Fund.
However, a fresh round of downgrades could bring about the possibility of the stress spreading to other sectors and issuers.
The Securities Exchange Board of India (SEBI) issued a circular on March 30, 2020, allowing relaxations to the rating agencies to go slow on credit rating reviews, i.e., downgrades and defaults, in the backdrop of disruption caused by COVID-19. “The actions taken so far by the rating agencies may have been after considering the relaxations or assuming the usual course of business. If the downgrades are done without going by the relaxation allowed by the SEBI, then we would see stability in ratings after the situation springs back to normal,” says Joydeep Sen, founder of wiseinvestors.in. “However, if the rating actions get reported even after going slow as per the regulator’s allowance, then things may not look good,” he adds.
This is not the first time that the credit quality of the bonds has gone down. CARE Ratings have seen modified credit ratio (MCR) – the ratio of upgrades and reaffirmations to downgrades and reaffirmations, hitting a six year low for the June quarter of FY2019-2020. A falling MCR points to declining credit quality and can be a cause for worry to investors.
How fixed income investments get affected
The deteriorating macroeconomic situation is expected to hit small and medium enterprises, and also those with relatively low credit ratings. Rising stress in the economy has already been captured in the performance of credit risk funds. According to Value Research, credit risk funds as a category lost 3.52 per cent on an average over the last one year.
When a bond is downgraded, the mutual fund schemes holding that instrument need to provide for it as per the guidelines issued by the Securities Exchange Board of India (SEBI), and the net asset value (NAV) of the scheme is brought down accordingly. Deteriorating credit outlook of an issuer is also visible in the prices of the bonds if they are traded on the exchanges. For example, some AA-rated bonds issued by non-banking financial companies in 2017 and 2018 at 11-12 per cent rate of interest now trade at a yield more than 15 per cent. Price discovery of these bonds is marred by poor volumes.
What should you do?
After the Franklin Templeton crisis, liquidity risk was high in bonds with low ratings. Credit risk funds can be avoided by investors looking for stability in returns.
“Stick to bond funds offering relatively low duration and high-quality bonds,” says Kumaresh. He prefers banking & PSU bond, short duration and corporate bond funds.
“Gilt funds, with no credit risk, have done well in the last one year, but can be volatile if you cannot hold them for a long horizon of say five or ten years,” says Joydeep.
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